How price benchmarks work Flashcards
Why does the commodities markets make such heavy use of benchmarks in their day-to-day business?
1) physical commodity deals vary greatly in terms of specifications. Deals can be either for import or export, while the size, quality, delivery, timing and payment terms all vary tremendously. If the price of every deal had to be negotiated from scratch, it would be very time consuming for the traders involved. Market participants prefer to just negotiate the cost of the difference between the general and specific
2) the volatility of most commodity prices makes it extremely difficult to predict. traders would never agree. Instead they will agree on a benchmark index that will broadly capture price changes. The traders will then focus on the size of the premium or discount to this index.
If an Indonesian importer wants to buy a cargo of gasoline from a Singaporean trading house in one month’s time, what are the two options they have for how to price the deal?
1) agree an overall price in US dollars for the cargo. a “flat price deal” (not a common way of doing it) spend a lot of time debating whether prices will fall or rise.
2) link the deal to a benchmark, e.g published assessment by platts, using the average of a number of daily assessments as the index
what is a flat price deal?
when two sides agree an overall price in US dollars , debathing between themselves what prices will do
Over how many assessments would sides take an average?
for Asian gasoline: 5 days
for asian crude oil: a month
give an example of benchmarks used throughout the supply chain
the singaporean trading house would have acquired the cargo from a refiner at a price from platt’s assessments, before selling it to the importer
what is basis risk?
the additional risk by using different benchmarks
what does the benchmark system ensure both sides can do?
ensures both sides can focus on the element of the price that they can control (the premium / discount) ad not on what they can’t (the flat price)
how would counterparties hedge themselves?
they can use derivatives to hedge against adverse moves in the underlying flat price by trading swaps or futures that also settle against the benchmark
What are indexes shorthand against?
they reduce friction in negotiations as both sides take on equal amounts of risk as both are exposed to the same index
What is professional and financial POV for our benchmark being used?
professionally, it means the industry trusts out assessments to be an independent arbiter of a contract price.
financially it means both parties have to subscribe to our data
Why is “first mover advantage” so important?
In benchmark and for PRAs its rare for the industry to switch from one PRA benchmark to the other
Why might an industry favour a PRA?
1) first mover advantage
2) they feel benchmark methodology is more representative/ better for compliance purposes
3) availability of related derivative markets
what is “the availability of a derivate market when picking a PRA?
participants will want to hedge their price exposure to a PRA by taking the opposite position in the derivatives market , they need to know that there are also liquid swaps or futures available for any specific benchmark
What s the most competitive commodity sector for PRAs?
energy market
who is a pioneer among PRAs?
PLatts is the benchmark in most energy markets
why did Argus become benchmark in Euopean biodeisel and biomass?
it was the ifrst PRA to report in depth about these
Which were the first benchmarks to move from platts to argus?
the european and asian LPG markets, because we moved from weekly assessments to daily.
What is the main factor in switcing PRAs?
methodology
Why did Platts acquire Asian crude oil benchmark from APPI?
APPI’s methodology was producing erroneous results and the market had more faith in Platts
Why did Argus acquire the European gasoline and US crude oil benchmarks from platts?
industry concerns about platts introduction of MOC (market on close) methodology
switching from an incumbent is….
rare
What is the most valuable PRA commodity benchmark?
Platt’s dated Brent assessment
Who has the LNG benchmark and why is it important?
PLatts, LNG has the potential to interupt regional pipeline gas markets
whats the ags markets saying in terms of which PRA assess them?
Agricultural markets are also still generally open for PRAs to establish benchmarks, although again Platts seems to be in prime position.
Why do so few commodity benchmarks change hands?
most traders don’t care about methodologies: just about profitability of their most recent trade
what is path dependency?
the continued use of a product or practise based on historical preference - usage will continue even if newer products are available
Why are switches of benchmarks opposed by wider market?
1) an innate suspicion: counterparties at other firms will assume a trader’s firm has found an angle to exploit
2) a natural buyer will typically be opposed by a seller. Anti trust rules also make it difficult for companies to get together and discuss the need to switch or not
Why are switches of benchmarks opposed by internal people?
1) her trading manager might be suspicious a switch in benchmark is to mitigate or cover up potential trading losses
2) it requires a second expensive PRA subscription
even if the whole industry decide on a switch, why can it not happen?
1) some companies would be locked into long term deals and they don’t want to change reference terms for fear the contract could be open to renegotiation
2) traders will have long term exposure to the incumbent benchmark through the derivatives market (brokers and traders will all need to be aligned in order to promote derivative contracts based o new RA assessments)
What are the commodity benchmarks no established by PRAs?
exchange benchmarks, official selling prices or posted prices, gvmnt-set prices and broker indices
